Wednesday, 11 May 2011

The role of economics in an imperfect world

In the New York Times Edward L. Glaeser discusses what economics has to contribute to the war of ideas. Given that no one seems to take any notice of what economists say I'm not that sure it really matters. Glaeser notes that

John Neville Keynes, the father of John Maynard Keynes, promulgated the distinction between positive and normative economics. Milton Friedman later made that division canonical.

Positive economics attempts to understand the world as it is; normative economics describes how the world should be. Most economists spend most of their time doing positive economics, but most economics columns advocate particular policies, which is implicitly normative economics.

Glaeser continues,

Positive economics, as usually practiced today, combines formal, mathematical models and lots of quantitative, statistical work. That’s not what economists did before World War II; Keynes’s General Theory is short on both formal models and statistics. But formal theory and statistics have triumphed, and that’s a good thing.

It's interesting that Keynes, the younger, didn't bother much with quantitative approaches given he was trained as a statistician.

In the wake of the recent crash and recession, it has become fashionable to deride the quants, whether on Wall Street or in the academy. After all, few of them saw it coming. The critics may be right to criticize excessive overconfidence, but they are wrong to suggest that the fault lies in either formal models or statistical work.

Hubris has been part of the human condition, with or without math, long before the Black-Scholes asset-pricing formula. Mathematical models create discipline. They ensure that we specify our assumption and that our conclusions then follow from our assumptions. Statistics then provide us with indispensable tests of our theories.

Glaeser adds a note of caution:

But we need to always remember that data and statistical tests never prove a theory. Typically, many different theories can explain almost any observed phenomenon. Data allows us only to reject a theory. The theories that survive are those that haven’t been rejected yet, and that’s a good reason for humility.

But what of normative economics? What place does it have in economic discussion and public policy development?

At its best, normative economics draws heavily on positive economics: scores of studies have shown the ways in which rent control can screw up a housing market, with too little supply and misallocation of housing units, and that helps formulate policy prescriptions.

Yet the economic approach to public policy is distinguished by attributes beyond an attention to evidence.

There is a strong predisposition within economics to emphasize individual freedom. Our theories start with the assumption that giving individuals more choices is a good thing — and that assumption leads to the view that people benefit from having more money or lower prices for the goods that they buy.

The basis ideas is that people know what is best for themselves and have the right to live by their assessment of what they want. In short, personal freedom. This does mean that all regulation is bad, in fact markets only work because they are regulated, in most cases by the people within the market and by competition.

That assumption doesn’t mean that all regulation is bad or even that, in some cases, people are better off facing fewer soups on a supermarket shelf. Even though people value more choices, they also value information, and an overload of choices can make it hard to figure out which soup is really best. But our assumptions do put freedom first, and that’s an important perspective.

Economics marries a predilection for personal freedom with a longstanding tendency to view the interests of the government as being distinct from the welfare of the people. Adam Smith’s “Wealth of Nations,” modern economics’ founding document, emphasized that point.

In the 18th century, it seemed clear that what was good for King George III was not necessarily good for Britain and certainly was not necessarily good for his American subjects.

Its worthwhile to keep in mind that both markets and governments are imperfect, and it's important to weigh their failures against each other - we need a comparative institutional approach. Always keep in mind that governments are not a faultless servant of the people's will, even assuming "the people" have a will. There is a healthy scepticism about the benevolence and competence of the state continued within economics.